07:19 AM EDT, 10/23/2024 (MT Newswires) -- The Canadian dollar continued to weaken against the US dollar ahead of Wednesday's Bank of Canada policy meeting, resulting in USD/CAD trading back above 1.3800 for the first time since late July/early August during the period of heightened financial market volatility, said Mitsubishi UFG.

Despite recent weakness against the US dollar, the Canadian dollar has been the second-best performing G10 currency this month as the US dollar has rebounded, wrote MUFG in a note to clients. It highlights that the performance of the Canadian and US dollar remain closely linked.

The Canadian dollar has derived some support from the recent rebound in the price of oil driven by the heightened geopolitical tensions in the Middle East. It has helped to provide an offset to the negative impact of yield spreads moving against the Canadian dollar, pointed out the bank.

Short-term yield spreads between the United States and Canada have widened sharply in favor of a stronger US dollar since early in September and hit fresh highs. At current levels, the spread is signaling that USD/CAD could attempt to climb above 1.4000.

The sharp widening in short-term yield spreads between the U.S. and Canada has been driven by expectations for policy divergence in the near term between the Federal Reserve and Canada's central bank, added MUFG. While the Fed is expected to slow down the pace of rate cuts at remaining policy meetings this year, the BoC is expected to speed up the pace of rate cuts starting at Wednesday's policy meeting.

The Canadian rate market has moved to fully price in a larger 50bps rate cut from the BoC at Wednesday's policy meeting. According to the latest Bloomberg survey, Canadian economists are less convinced with 14 out of 23 economists forecasting a 50bps rate cut on Wednesday.

In light of recent guidance from the BoC, softer inflation and looser labor market conditions, MUFG expects the BoC to deliver a larger 50bps cut.

For the Canadian dollar to weaken significantly after Wednesday's meeting the BoC would also have to indicate that it remains open to another larger cut as soon as the next meeting in December. The main catalyst for a break above the 1.4000 level for USD/CAD before year-end would be a Donald Trump and Red Sweep U.S. election outcome, according to MUFG.